Options and Futures Markets

Options and Futures Markets

______

BAFI 430

Spring 2001

Futures and Options Markets

Instructor Peter Ritchken

Tel. No. 368-3849

Fax. No.368-4776

My web page is:

The Course Material will be posted on the BAFI 430 section of my web. page.

Overview:

Markets for futures, options and options on futures have mushroomed over the last decade, and new products continue to be introduced. Markets in Europe and Asia are growing rapidly as well. Indeed, over the last decade the volume of derivative trading has grown at an annual rate of about 30%. These financial innovations allow firms to lay off stock market risk, commodity risk, exchange rate risk and interest rate risk. Over-the-counter markets have experienced even more dramatic growth. Over the last 5 years they have grown 800%. Such contracts are tailor designed by brokerage firms and investment banks to meet the very specific needs of their corporate clients.

In BAFI 430 you will study the basics of forward, futures and option markets. You will learn how to use these markets in an intelligent way. Hedging and insuring applications will be covered in some detail.

After taking this class you will be able to:

Communicate the risk management needs faced by the firm and to isolate the steps needed to solve the problem.

Explain the why certain products and strategies create value while others do not.

Distinguish when hedging is appropriate.

Price contracts and prevent being ripped off.

In addition you will be aware of the impact of technology on trading strategies and be aware of choices of products, not only in the U.S., but also in Europe and Asia.

The array of options and futures, as well as other derivative securities is unbelievably large. An understanding of these products is essential for almost anyone interested in any aspect of corporate finance, even if the area excludes investments. For example, if your interests are in mergers and acquisitions, international business or international finance, then an understanding of the valuation issues associated with derivatives is essential.

The grade for the course will be determined as follows:

Mid Term40%

Final45%

Homework10%

Project 5% (plus grade tie-breaker, if necessary)

The Mid Term Exam Date will be scheduled on Tuesday March 20th. The Final Exam is scheduled for the Tuesday of exam week.( Dec 11th).

Options and Futures Day

The Class on Tuesday April 10th is cancelled. Instead, we will have a Saturday make up class, with the date determined shortly.

Project

The project does not count that much in your grade. However, if you are on the border between grades, the project will be used to determine whether you get the higher or lower grade. You can do the project in small teams or individually. The larger the team the bigger the scope of the project. I will discuss the format of the project in more detail in class. The topics for the presentation can be any area that involves risk management. Once you have an idea, then you need to have it approved by me. I will make frequent suggestions for projects throughout the semester.

One goal of the project is to get you to do a bit of independent reading beyond The Wall Street Journal. Risk Magazine is an excellent source for ideas on projects.

Homework

Homework should be turned in on time. If not, do not bother to turn it in. Your lowest grade on a homework will be discarded. All homework assignments carry equal weight. Full solutions will be provided to the homework problems.

Office Hours

I have office hours on Tuesday afternoon, 4.30 – 6.00pm, or by appointment. If you cannot see me during the scheduled window, you need to make an appointment to see me. For part time students, perhaps you can call me in my office during office hours and I can respond to your questions on the phone or set up an appointment.

If you haveurgent questions then you can e-mail me. All questions regarding grading of homework should be initially directed to the grader of the class. She will have office hours during which time she can assist you with any questions related to the homework, or she will review some of the material covered in class. Please do not e-mail me your homework.

Grader: To be announced

Tel.

Office:

Office Hours

Email :

Textbook:

Option and Futures for BAFI 430 course notesby Peter Ritchken, will be posted on my web page.

Some of my class overheads will also be posted on my web page for you to download.

You do NOT need to purchase any text for the class. I will not distribute copies of the chapters of my textbook in class.

You are required to get the Wall Street Journal.

Recommended Reading:

Options, Futures & Other Derivatives, 1999, Fourth Edition, by John Hull, Prentice Hall.

I have ordered this book, and it is in the bookstore. It is a great book, and I urge you to get it. It is an excellent reference especially for students with a strong math background who want a deeper understanding in the subject area..

Futures, Options and Swaps, Robert Kolb, Kolb Publishing Co., 1994

This book is also excellent, has great examples, and is less technical than Hull’s book.

Introduction to Futures and Option Markets, Third Edition, John Hull, Prentice Hall.

This book is an undergraduate version of Hull’s other book (above) and is very readable.

Portfolio Simulations:

In this class we will use PRM Simulation. This computerized trading game provides a very quick way of grasping the options market. Prices are not actual prices but are simulated. One advantage of PRM is that you can play with multiple accounts over a “one year” period in one computer session.

Recommended Study

I recommend that you read the chapter we are going to cover before coming to class. This will increase your understanding of the class material. A final reading after class should reinforce the concepts.

I also recommend that you solve as many problems as you can.

Those of you who desire to pursue a career in the financial industry may want references to other advanced textbooks and journal articles. I will be happy to advise you on such references and discuss the material with you.

A Tentative Course Outline

Below is a tentative course outline. We may adjust it from time to time depending on how the class proceeds. For example, we might focus in on certain topics in more detail. The risk management function will be emphasized throughout. Less attention will be placed on the actual market structures and operations of exchanges. I will assume that you have done all the readings that I assign, ahead of schedule.

Lecture 1:

An Overview of the Class.

Why is Risk Management Important?

Why do firms hedge?

Uncertainty in Equity Markets, FOREX, commodity markets, interest rates.

The wide variety of products.

Why are more products better than fewer products?

The law of one price.

Examples of the law of one price.

Interest rates, present values and money funds.

Forward Contracts.

Readings: Chapter 1

Lecture 2 and 3

Forward Markets and Futures Markets

Valuing Forward contracts

Valuing Futures contracts.

The relationship between forward and futures prices

Pricing forward contracts.

Arbitrage relationships.

The term structure of futures prices and basis risk.

Readings Chapter 2, Parts of Chapter 3

Lecture 3 and 4

Hedging with Futures Contracts.

Basis risk

Long and Short Hedges.

Risk Minimizing Hedges.

Issues in Hedging. The MG Case Study

Readings: Chapter 3, Notes and Handouts

Lecture 5

Options

Option Strategies.

Hedging with Options

The Computer Simulation Game.

The Wide Variety of Option Contracts.

Readings: Chapter 4 and 5

Lecture 6

Option Arbitrage Relationships.

Pricing Bounds

Put Call Parity

Empirical Evidence.

Readings: Chapter 6

Lecture 7

Modeling the Dynamics of Prices

Evolution of Uncertainty.

The Geometric Wiener Process

The Binomial Process

Confidence Intervals of Prices over time.

Computer Simulations in Excel.

Readings: Chapter 7

Lecture 8 and 9

Option Pricing Models

The Binomial Option Pricing Model.

The Black Scholes Model

Readings Chapter 8 and 9

Lecture 9 and 10

Risk Management with Options

The Greeks

Managing Non linear Risk

Identifying Toxic Waste!

Readings: Chapter 10

Lecture 11

Pricing Options on Futures, Stock Indices, Foreign Currencies

Impact of Dividends

Merton’s Model

Examples on lattices

Risk Management of optioned positions

Readings: Chapter 12

Lecture 12

Simulation of Stock Prices and Option Pricing

Simulation in Excel

Simulating a Lognormal Process

Simulating Option Prices

Simulating Exotics

Readings: Handouts

Lecture 13

Special Topics

Corporate Securities and Hybrids

Exotic Options

Credit Derivatives

Readings: Handouts

Lecture 14 - 15

Special Topics ( Time Permitting)